Iceland Central Bank Cuts Key Interest Rate to 17%

By Helga Kristin Einarsdottir

March 19 (Bloomberg) -- Iceland’s central bank cut the benchmark interest rate by 1 percentage point after the severest recession since World War II and a slump in consumer demand eased pressure on prices.

Policy makers lowered the repo rate to 17 percent from a record, the Reykjavik-based bank said in an announcement on its Web site. The rate cut is the first since the island came under International Monetary Fund administration in November.

“There was considerable uncertainty surrounding this decision,” said Ingolfur Bender, head of economic research at Islandsbanki, the state-controlled unit of failed Glitnir Bank hf. “I expect rates will be lowered in smaller, more frequent steps to test the market in the future.”

The bank has scope to lower borrowing costs as the prospect of a 10.5 percent economic contraction this year squeezes inflation faster than expected, IMF Mission Chief Mark Flanagan said on March 13. Capital restrictions and a managed float of the krona have supported the currency’s 12 percent gain against the euro this year, also reducing price pressures.

“The crisis has led to a sharp drop in economic activity, the krona has stabilized and inflation appears to have peaked,” Flanagan said last week.

The failure of the country’s biggest banks slashed more than two thirds off the value of the krona last year, pushing price gains close to 20 percent and sending unemployment to a record high. The inflation rate fell to 17.6 percent in February, from a 19-year high of 18.6 percent the month earlier.

Capital Restrictions

The krona was little changed against the euro and traded at 152.86 as of 9:18 a.m. in Reykjavik.

The central bank won’t be able to remove capital restrictions as long as global economic turmoil persists, Flanagan said last week. About 700 billion kronur ($6 billion) in foreign-held krona-denominated debt is at risk of being cashed in when capital flows are freed, according to Thorfinnur Omarsson, a spokesman at the Business Affairs Ministry.

Iceland got an IMF-led loan of $5.1 billion in November to help it rebuild the crippled economy, the fifth-richest per capita as recently as 2007. The government was forced to seize Kaupthing Bank hf, Landsbanki Islands hf and Glitnir Bank hf within a week because they couldn’t get short-term funding.

Acting central bank Governor Svein Harald Oeygard replaced David Oddsson last month after the interim Social-Democrat Left- Green coalition ousted the former prime minister who oversaw the privatization of the failed banks and became a target of street protests demanding the resignation of key policy makers in office during the island’s economic collapse.

The central bank will publish the rationale behind today’s decision at 11 a.m. local time.

To contact the reporter on this story: Helga Kristin Einarsdottir in Iceland at einarsdottir@bloomberg.net.